AUG Market Update 2019

The Fed Gets It Right ... for the Right Reason?

Ronald Temple, CFA, Managing Director, Co-Head of Multi-Asset and Head of US Equity David Alcaly, CFA, Research Analyst

On 31 July, the Federal Open Market Committee (FOMC) cut its target for the rate by 25 basis points (bps), com- pleting an about-face that began last year. Over the past seven months, the FOMC has moved from hiking rates, to remaining “patient,” to acting “as appropriate to sustain the expansion,” despite limited evidence of unexpected economic weakness. At the same time, the has launched a review of its strategy, tools, and communications, focused in large part on the chal- lenges low interest rates, low growth, and low inflation pose for monetary policy.

We believe that the FOMC has made the right decision in reducing rates. As we have long argued, the case for hiking rates aggres- sively last year was weak and there are clear benefits to running a “high pressure economy.” Furthermore, the risks surrounding inflation remain to the downside—core PCE inflation has hit the target of 2% in just 6 of the past 86 months. The combination of the FOMC’s pivot in short-term policy with the broader review of how the Fed makes policy more generally suggests that the Committee might have come around to this point of view and narrowly averted a policy mistake.

We recognize that unpredictable trade policy could change the economic environment. That said, while there are some pockets of weakness, we believe the US outlook remains solid and has not changed dramatically since December. Current conditions suggest that a reasonable argument can be made for a few “insurance cuts,” but not a full easing cycle. We believe the FOMC should support con- tinued growth to secure the continued benefits from tight labor markets and to aspire to a period of above-target inflation, in keeping with the theoretical “symmetry” in its inflation target.

However, despite an emphasis on transparency, the FOMC has had a lot of trouble explaining its pivot. Both at the beginning and at the end it has had to walk back statements that were misinterpreted by markets. We expect continued market uncertainty about the number of rate cuts ahead, with investors focused on the Fed’s busy speaking schedule. We hope that the results of the Fed’s review—expected in early 2020—add clarity by demonstrating that the Fed is adopting a new policy framework with more emphasis on supporting maximum employment and raising inflation, rather than containing it. We also would advocate a new communications framework focused on higher quality, rather than higher frequency, communications. The Right Decision ... We have long believed the argument for aggressive rate hikes was weak, and that the FOMC ought to want to realize above-target inflation on a sustained basis before tightening policy. Our view is mainly based on three factors: 1) the expansion has been weak; 2) there are significant labor market benefits from allowing the economy to “run hot;” and 3) there is little risk of undesirably high inflation.

First, the recovery from the global financial crisis has been slow and weak. The actions taken by the Fed limited the financial crisis’s severity and contributed to what is now the longest US expansion since at least the 1850s. Fiscal stimulus also helped initially, but was too small and was withdrawn too quickly. However, growth in both real GDP per working age population and in total nonfarm payroll employment has been slower this expansion than in all other postwar expansions, with the exception of the pre-crisis expan- sion—itself a disappointment. As a result, estimates of both the level and the growth rate of potential output are lower today than they were before the crisis. For example, the Congressional Budget Office (CBO) estimate of potential US real GDP is more than 10% below its pre-crisis estimate

LR32041 2

(Exhibit 1). This implies that more should have been done to support growth and that doing too little may have reduced future growth and Exhibit 1 Estimates of Potential Output Have Been Heavily Cut economic well-being, through foregone investment, sustained under- US Real GDP employment, and depressed labor force participation. (1Q 2001=100) Second, there have been clear labor market benefits from running what 160 called a “high pressure economy,”1 reversing some of these effects. A range of measures suggest that much of the potential work- 140 force was slow to benefit from the recovery, but has since experienced improved prospects as the unemployment rate has fallen to its lowest 120 level in nearly five decades. For example, a large number of people withdrew from the labor force entirely following the crisis, a dynamic 100 not captured by the unemployment rate, which only measures individu- 80 als actively looking for work. While separating cyclical trends from 2001 2004 2007 2010 2013 2016 2019E 2022E structural trends is complicated, the share of prime age (25–54) adults in US Real GDP CBO Estimate of Potential Real GDP, Jan 2007* the labor force bottomed in 2014 for men and in 2015 for women. The CBO Estimate of Potential Real GDP, Jan 2019 decline since has returned 0.6 million men and 1.3 million women to As of March 2019 the labor force (Exhibit 2). Similarly, the share of prime age adults not * Original value in chained 2000 US dollars. Adjusted based on 1Q 2000 output gap. in the labor force due to illness or disability rose by over a percentage Source: Bureau of Economic Analysis, Congressional Budget Office, Haver Analytics point from 2001 to 2014, but has since declined.2 The FOMC’s economic projections demonstrate an evolving understanding that tight labor markets are more sustainable than Exhibit 2 previously thought. The lowest FOMC projection of the longer-run Tighter Labor Markets Are Drawing People Back into the Workforce unemployment rate increased from 4.5% in January 2009 to 5.2% Labor Force Participation Rate in late 2013 and early 2014, before many of the benefits of tighter labor markets were realized. Since then, the median FOMC projec- (Pre-Crisis Peak =100) 101 tion of the longer-run unemployment rate has declined to 4.2% and the lowest FOMC projection has fallen to 3.6%. At his 31 July 2019 100 press conference, Chair Jerome Powell explicitly acknowledged the Female, Age 25–54 benefits tight labor markets were having: 99 Wages have been rising, particularly for lower-paying jobs. People who live and work in low- and middle-income 98 communities tell us that many who have struggled to find work are now getting opportunities to add new and better chapters to their lives. This underscores for us the importance 97 of sustaining the expansion so that the strong job market Male, Age 25–54 reaches more of those left behind.3 96 2007 2009 2011 2013 2015 2017 2019

Third, we believe the risks surrounding inflation are clearly to the As of July 2019 downside. The experience of the “Great Inflation” of the late 1960s– Source: Bureau of Labor Statistics, Haver Analytics early 1980s has biased Fed policy toward “getting ahead of the curve” based on the idea that being too tolerant of tight labor markets could lead to rapidly accelerating inflation, forcing drastic rate hikes that subsequently cause a recession. These risks are very low today. The Exhibit 3 Great Inflation took time to develop and occurred under far different Core PCE Inflation Last Hit 3% in 1992 circumstances. The last time core PCE inflation was as high as 3% was Personal Consumption Expenditures Less Food and Energy in 1992, during its decline from that episode (Exhibit 3). This cycle, YoY Change (%) 12 core PCE has only hit the Fed’s target of 2% in six months since April 2012, all in mid-2018. It has since moved in the wrong direction, fall- ing to 1.6% even as labor markets tightened further. Furthermore, the 9 slow recovery in the United States, as well as even slower growth and weaker inflation in other advanced economies, strongly suggests that 6 inflation pressures are weak globally.

There also is every reason to believe that the Fed could easily con- 3 tain inflation if necessary. Inflation has been relatively insensitive to changes in the unemployment rate in recent decades. It is highly 0 unlikely that it will accelerate uncontrollably, much less that this 1969 1979 1989 1999 2009 2019 would happen suddenly and from such a low level. Interest rates As of June 2019 remain very low, suggesting that small rate hikes could slow activity. Source: Bureau of Economic Analysis, Haver Analytics And the Fed has an unlimited ability to tighten policy. The much 3

more worrisome future constraint is its limited ability to cut rates and implement other unconventional policies in a recession, a limitation Exhibit 4 Markets Were More Dovish than the FOMC that is exacerbated by persistently low inflation. Projected Fed Funds Rate All of these points suggest the FOMC should maintain easy policy (%) even as labor markets continue to tighten, at least until above-target 3 inflation is realized on a sustained basis. In fact, rather than seeking to “get ahead of the curve,” the FOMC should want to see higher infla- tion. This idea is implicit in some of the monetary policy strategies 2 currently under the Fed’s review, such as average inflation targeting or price level targeting. We hope the FOMC’s pivot in short-term policy, combined with the broader review of how the Fed makes policy, 1 reflects that the Committee has come around to this point of view Jan 18 Jul 18 Jan 19 Jul 19 Jan 20 Jul 20 while avoiding a policy mistake. Fed Funds Futures, 7/29/2019 Fed Funds Futures, 9/24/2018 Fed Funds Futures, 3/18/2019 Most Dovish FOMC Projection, 6/19/2019 Fed Funds Futures, 12/17/2018 ... for the Right Reason? Target Fed Funds Rate As of 29 July 2019 However, the speed of the FOMC’s U-turn leaves plenty of room for Source: Bloomberg, Federal Reserve, Haver Analytics uncertainty. At the FOMC’s September 2018 meeting, the median participant projected three rate hikes in 2019, on top of four in 2018—clearly a policy trajectory far too concerned with inflation. By Nonetheless, the FOMC has had trouble explaining its pivot, despite March 2019, the median projection was for no hikes in 2019. By June an emphasis on transparency and plainer language under Chair 2019, seven participants were forecasting two rate cuts in 2019. Powell. For example, on a number of occasions markets have reacted strongly to Fed speeches independent of changes in economic data or Most US economic data has not been as disappointing as this rapid news—a whipsawing of expectations that is counterproductive. Two change would seem to imply. Real GDP rose by over 2.5% annual- such episodes framed the recent pivot: ized in the first half, roughly in line with its expected trajectory. Labor markets remained strong, with average jobs growth well above the • Markets rallied after Chair Powell’s speech at the Economic Club level required to keep pace with population growth, implying that of New York on 28 November 2018, in which he said interest rates the unemployment rate is likely to fall further. Core PCE inflation were “just below” what some considered to be neutral5—a seem- weakened earlier in the year and remains low at 1.6% year on year, but ingly explicit correction of an October interview in which he said it has improved in recent months as the FOMC suggested it might, “we are a long way from neutral at this point.”6 rising 2.5% on a 3-month-annualized basis in June. • Markets rapidly raised the probability of a 50-bp rate cut at the 31 As the FOMC has highlighted, the biggest source of weakness has July meeting (Exhibit 5) following an 18 July 2019 speech by New been the global economic environment and rising trade tensions. York Fed President John Williams in which he said that “it pays 7 Data from exposed sectors has been soft and continued uncertainty to act quickly to lower rates at the first sign of economic distress.” over trade policy could weigh on investment and hiring decisions. Later that evening, a spokesman took the highly unusual step of Real business investment was a drag on growth in the second quarter clarifying that the speech was “academic” and not a suggestion that 8 and surveys suggest that trade is increasingly a concern for many Williams supported a large interest rate cut. businesses. Ultimately, we believe this is an issue the Fed should address in In this environment, there is a reasonable argument for a few “insur- its review. A higher volume of communication does not increase ance cuts” to bolster activity and add credibility to the FOMC’s willingness to ease further if necessary, but not a full easing cycle. However, ahead of the FOMC’s 30–31 July meeting, markets were Exhibit 5 pricing a more dovish outcome (Exhibit 4). Chair Powell appeared to Markets React Rapidly to Fed Speak address this uncertainty at his press conference, emphasizing that the Market Implied Probabilities for 31 July FOMC Meeting rate cut was a “mid-cycle adjustment”—a reference to the two 75-bp (%) 100 adjustments of the mid-1990s—and not the beginning of a “long series” of rate cuts.4 75 We expect guiding market expectations in this way to be an ongoing challenge for the FOMC. The rapid pivot—and fine-tuning of policy 50 near the peak in the fed funds rate—means that incoming economic data is a less reliable guidepost for what the FOMC will do, making 25 markets more sensitive to what the FOMC says. Furthermore, if the 0 pivot is indeed a reassessment of the FOMC’s relative concerns with May 19 June 19 July 19 growth and employment versus inflation—more of a change in the No change 25-bp cut 50-bp cut FOMC’s “reaction function” than in the “data”—the natural vehicle As of 30 July 2019 for shifting guideposts is the Fed’s review of its strategy. Source: Bloomberg, Renaissance Macro Research 4

transparency in a meaningful way if it contributes to noise and In this regard, we hope that the results of the Fed’s review of its short-termism. Rather, a focus on raising the quality of communica- monetary policy strategy, tools, and communications in early 2020 tions would be preferable, in line with three objectives discussed at demonstrate that the FOMC shares this view. We believe that this a recent Fed Listens event: “simplifying public statements, clarify- is an important and necessary exercise with the potential to re-align ing how policy will react to changing conditions, and highlighting policy strategy with the realities of today’s economy and to re-align uncertainty and risks.”9 “transparency” with clear communications objectives. Across the major developed economies, the primary monetary policy Conclusion challenge is supporting economic expansion and employment in an In sum, we believe the FOMC is right to move away from tighten- environment of low inflation, low growth, and low rates. Addressing ing monetary policy. The recovery from the global financial crisis has this challenge is even more pressing because the response to the been slow and weak, tight labor markets appear to be benefiting the financial crisis has left central banks with less ammunition to fight economy, and the FOMC should be more concerned with raising future recessions. Identifying what more can and should be done is a inflation than containing it. Our expectation is that, having completed pressing mission. its pivot, the FOMC will cut rates once or twice more and focus on the larger challenge of adapting policymaking to the current environ- ment and improving its communication to further that mission. Unpredictable trade policy and its implications for the economic out- look could complicate this process. Market Update

This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm.

Notes 1. Yellen, Janet. 14 October 2016. “Macroeconomic Research After the Crisis.” 2. Tedeschi, Ernie. 15 March 2018. “Will Employment Keep Growing? Disabled Workers Offer a Clue.” New York Times. 3. Federal Reserve. 31 July 2019. “Transcript of Chair Powell’s Press Conference.” 4. Ibid. 5. Powell, Jerome C. 28 November 2018. “The Federal Reserve's Framework for Monitoring Financial Stability.” 6. PBS. 3 October 2018. “Judy Woodruff interviews Federal Reserve Chairman Jerome Powell.” 7. Williams, John C. 18 July 2019. “Living Life near the ZLB.” 8. Derby, Michael S. and Timiraos, Nick. 18 July 2019. “New York Fed Says Williams Wasn’t Sending Specific Policy Signal in Speech.” Journal. 9. Cecchetti, Stephen G. and Schoenholtz, Kermit L. May 2019. “Improving U.S. Monetary Policy Communications.”

Important Information Published on 9 August 2019. Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opin- ions expressed herein are as of the published date and are subject to change. This document reflects the views of Lazard Asset Management LLC or its affiliates (“Lazard”) based upon information believed to be reliable as of the publication date. There is no guarantee that any forecast or opinion will be realized. This document is provided by Lazard Asset Management LLC or its affiliates (“Lazard”) for informational purposes only. Nothing herein constitutes investment advice or a recommendation relating to any security, commodity, , investment management service or investment product. Investments in securities, derivatives and com- modities involve risk, will fluctuate in price, and may result in losses. Certain assets held in Lazard’s investment portfolios, in particular alternative investment portfolios, can involve high degrees of risk and volatility when compared to other assets. Similarly, certain assets held in Lazard’s investment portfolios may trade in less liquid or efficient markets, which can affect investment per- formance. Past performance does not guarantee future results. The views expressed herein are subject to change, and may differ from the views of other Lazard investment professionals. This document is intended only for persons residing in jurisdictions where its distribution or availability is consistent with local laws and Lazard’s local regulatory authorizations. Please visit www.lazardassetmanagement.com/globaldisclosure for the specific Lazard entities that have issued this document and the scope of their authorized activities.